As a public employee the few times my coworkers discuss RRSPs—usually around this time of year when we get pummeled by ads—the topic tends to circle around that fat tax refund cheque.
Personal finance is not a strong suit of most public employees (because all we tend to think about is that shiny, glittery, oh-so-far-away Gold-plated Pension). We know that drool-worthy and deplored pension is not as great as you think, but it's still alright.
So should someone with a defined benefit pension coming their way still contribute to RRSPs?
We know that RRSPs benefit pretty much everyone when you contribute in high earning years (when you're in a high tax bracket) and withdraw in low earning years (when you're in a low tax bracket).
The tax break Ottawa gives you now when you contribute is temporary. That big hand will be out to take their share when you withdraw from your RRSP/RRIF down the road. On standard RRSPs you contribute up to your RRSP contribution limit ("RRSP room"), you get the tax refund, you invest the money wisely and let it grow, and you pull out the money and pay normal taxes on it later.
From our RRSP Baby Fund post, we briefly touched on Spousal RRSPs. You open a spousal RRSP and designate your spouse or common-law as a beneficiary. Uou contribute up to your RRSP contribution limit, you get the tax refund, you invest the money and let it grow, BUT *after not contributing for 3 years* your beneficiary partner gets to pull the money out and pay normal taxes on it at their income level.
The Defined Benefit Pension Conundrum
DB pension plans reduce your RRSP contribution room each year by what's called the Pension Adjustment. The Pension Adjustment can be calculated in different ways depending on your pension plan. Just so you don't screw up and over-contribute to your RRSP, always check your RRSP contribution limit on your CRA Account. (If you haven't done so already, sign up!)
When you have a DB pension, you can quite easily estimate your benefit in retirement based on today's numbers. For example, if I expect to be promoted twice before retirement at age 55, my expected salary at that position will be $100,000. I will have 30 years of service and my benefit is set at 2% of each year worked. Therefore I can reasonably expect to receive a pension benefit of $60,000 a year. Under current tax laws, I can split this pension benefit evenly with my spouse to save on taxes.
When I take my $100,000 salary and deduct the Pension Adjustment, my taxable salary will be around $88,000. I'm left with $6,000 of RRSP room after the Pension Adjustment. That puts me in the 30.5% tax bracket for my additional RRSP contributions (up to that $6,000 limit in RRSP room).
If we split the $60,000 expected pension benefit so my spouse and I are both at the $30,000 income level, my spouse and I will only pay a 25% tax rate in Alberta. We're in that bracket on any income up to $46,000. It is clear there is some benefit to using RRSPs as I'm claiming a 30.5% deduction on contributions and paying just 25% tax on withdrawals. Unfortunately in most cases, it is not enough to beat out contributing to a TFSA.
What to Do?
The first option for everyone with a pension should be should be cramming those TFSAs full. It doesn't matter if we fill my TFSA or my spouse's TFSA because the income is not reportable anyway. Under current tax directives, you can contribute to your spouse's registered account without needing to justify where the income came from.
Growth with no future tax liability is amazing and the main reason why I love the TFSA so much. Filling a self-directed Questrade TFSA account and investing in a disciplined strategy is a fantastic way for a future pensioner to save for a very lucrative retirement lifestyle with low taxes.
Following the TFSA, the next step would be using a spousal strategy to split RRSP contributions and income as evenly as possible. If I have a low income spouse with no pension plan it's a no-brainer to open a Spousal RRSP.
I can contribute up to my RRSP limit and take a 30.5% tax break. As long as we contribute evenly to my personal RRSP and the Spousal RRSP (again up to my total contribution limit), we can not only split the DB pension benefit, but also set up an evenly split RRSP income stream. As a couple we can realize decent tax savings through strategic income splitting by keeping both incomes in low tax brackets.
The last option is the joint Cash/Margin account. Investing in this account doesn't offer any tax benefits on contributions, but withdrawals can be split and are taxed a significantly lower rates than standard income. Only half the realized capital gains in a year are taxed. Canadian dividends are taxed less than 8% for incomes below $91,000 in Alberta.
The problem with Cash/Margin accounts is I will be taxed on capital gains and dividends that are realized during my working years and this can reduce the overall return of the money invested in this account. Done right it should only reduce returns by about 0.5%, but this does add up over time.
Example of Strategies
Let's look at a visual comparison of the three options for a $4,600 contribution (adds up to $6,000 after reinvesting the 30.5% RRSP tax refund) which would max out RRSP room for my $100,000 salary employee in Alberta with a $12,000 Pension Adjustment that we talked about earlier.
The pension benefit will be $60,000 ($30,000 each after splitting). We will assume a 30 year timeline and a lower-income spouse with no pension plan. We will also assume that, of the $17,250 in expected annual withdrawals from the joint Cash/Margin Account, 50% will be Canadian dividend income and will be 50% capital gains income, both evenly split between the couple.
It's important to remember that $2,000 or $3,000 a year might not look like much at first glance, but over a long retirement it adds up to tens of thousands. That can pay for some nice vacations, spoiling the grandkids, or improving your quality of care in very old age.
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